STATE UNIVERSITIES RETIREMENT SYSTEM SURS. Fiscal Year 2017 Investment Plan

Transcription

1 S U R S STATE UNIVERSITIES RETIREMENT SYSTEM SURS Fiscal Year 2017 Investment Plan September 2016

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3 September 1, 2016 Board of Trustees State Universities Retirement System 1901 Fox Drive Champaign, IL RE: Fiscal Year 2017 Investment Plan Dear Board of Trustees: The Investment Staff is pleased to provide the SURS Investment Plan for Fiscal Year This document was developed in order to formalize the strategic plans for the investment portfolio for the coming year and provide transparency of the planning process. The Investment Plan for Fiscal Year 2017 marks the sixth year of the formal plan for the SURS investment program. The Investment Plan reviews the results of Fiscal Year 2016 and defines the strategy for Fiscal Year 2017 in accordance with the Board-approved asset/liability study and Investment Policy. Since financial markets are dynamic, revisions to the plan may be required and will be communicated to the Board in a timely manner. The SURS portfolio returned 0.2% during Fiscal Year 2016, net of fees, trailing the policy portfolio return of 0.8%. Weak investment manager performance in the domestic equity and fixed income asset classes contributed to the relative underperformance for the period. From a long term perspective, the SURS portfolio has performed well, earning an 8.1% annualized rate of return over the past 25 years, well in excess of both the policy portfolio return and the 7.25% assumed rate of return. When compared to a universe of other large public funds, the SURS return ranks near median for the one-, three- and five-year periods ending June 30, The portfolio ranks near the top quartile in the peer universe over longer time periods. As of June 30, 2016, the defined benefit plan is valued at approximately $16.8 billion while the Self-Managed Plan (SMP) is valued at approximately $1.8 billion. Many of the projects completed during FY 2016 focused on continuing implementation of the asset allocation policy targets approved by the SURS Board in June The new policy targets focus on increased portfolio diversification, with a reduction in the equity allocation and new commitments to emerging market debt, commodities and hedged strategies. SURS completed searches in private equity (emerging manager mandate), hedged strategies, commodities, and portfolio index option overlay. In addition, SURS took steps to continue its

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5 FY 2017 Investment Plan Table of Contents Page I. Purpose...1 II. Overview 2 Background Fiscal Year 2016 Performance Review Fiscal Year 2016 Accomplishments Challenges Trustee Education Corporate Governanace Investment Management Fees Staffing Outreach III. IV. Asset Allocation / Risk Management 12 Economic Outlook..19 V. Fiscal Year 2017 Portfolio Strategies Total Fund Equity Fixed Income Real Estate Private Equity Hedged Strategies Opportunity Fund Commodities VI. VII. Manager Diversity Program 30 Self-Managed Plan....32

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7 I. Purpose The Investment Plan reviews the results of Fiscal Year 2016 and defines the strategy for Fiscal Year 2017 in accordance with the Board-approved asset/liability study and Investment Policy 1. This Plan is intended to be a living document. Since financial markets are dynamic, revisions to the plan may be required during the year. In the event of changing circumstances or opportunities during the year, items will be discussed with the Board as necessary. 1 The SURS Investment Policies can be found at 1 FY2017 Investment Plan

8 II. Overview Background The State Universities Retirement System (SURS) is the administrator of a cost-sharing, multiple employer public employee retirement system. SURS membership includes employees of the public universities and other affiliated organizations. Currently, SURS membership totals more than 230,000 active, inactive and retired participants. SURS maintains both a defined benefit and a defined contribution plan, known as the Self-Managed Plan (SMP). As of June 30, 2016, the defined benefit plan is valued at approximately $16.8 billion while the SMP is valued at approximately $1.8 billion. The investment portfolio is broadly diversified across equities, fixed income, real estate, private equity, commodities and other opportunistic investments. Approximately 42% of the portfolio is currently managed in passive or structured active strategies while the remaining 58% is managed in active strategies. Fiscal Year 2016 Performance Review Global financial markets continued to experience heightened levels of volatility and provided mixed performance over the course of the fiscal year due to both economic and political uncertainty. Although the U.S. equity market spent much of FY 2016 in negative territory, markets rallied toward the end of the period to produce a small positive return. The Dow Jones U.S. Total Stock Market Index ended the fiscal year with a return of 2.0%. Equity markets outside the U.S. did not fare as well, however, returning -10.2%, as measured by the MSCI All Country World ex-u.s. Index. Interest rates in the U.S. continued to decline from already low levels, with the yield on the 30-year U.S. Treasury bond falling from 3.1% to 2.3% over the course of the fiscal year. Accordingly, core fixed income markets returned 6.0% while Treasury Inflation Protected Securities returned 4.4% during the fiscal year period. Direct real estate and real estate investment trust securities (REITS) provided the strongest absolute returns during the fiscal year, as evidenced by the +12.6% return of the NCREIF ODCE Index, an index of open end direct real estate funds and the +11.6% return of the FTSE EPRA/NAREIT Developed Index. The table below illustrates the performance of the overall SURS investment portfolio relative to the policy portfolio, as of June 30, The SURS portfolio returned 0.2% during Fiscal Year 2016, lagging the policy portfolio return by approximately 0.6%. Investment Performance* As of June 30, Year 3 Years 5 Years 10 Years 20 Years 25 Years SURS 0.2% 6.8% 6.6% 5.9% 7.3% 8.1% Policy Portfolio 0.8% 7.0% 6.9% 6.0% 7.2% 7.8% *Net of investment management fees. 2 FY2017 Investment Plan

9 On a relative basis, the domestic equity and fixed income portfolios were the biggest detractors to the overall portfolio s performance. The aggregate underperformance in the domestic equity portfolio can be attributed to a combination of structural factors (slight tilt toward small and mid cap stocks) and poor performance by the underlying active investment managers during FY The fixed income portfolio also lagged its benchmark due to a combination of factors. Approximately half of the underperformance in the fixed income portfolio can be attributed to structural factors (presence of an unconstrained mandate) while the other half can be attributed to underperformance by several active fixed income managers. Although the non-u.s. equity asset class provided weak absolute returns, the portfolio performed well compared to its benchmark due to strong relative performance by active managers. From a long term perspective, the SURS portfolio has performed well, earning an 8.1% annualized rate of return over the past 25 years, well in excess of both the policy portfolio return and the 7.25% assumed rate of return 2. When compared to a universe of other large public funds, the SURS return ranks near median for the one-, three- and five-year periods ending June 30, 2016, as illustrated in the chart that follows. The portfolio ranks near the top quartile in the peer universe over longer time periods. SURS Total Fund vs. Public Funds > $1 Billion Periods Ending 6/30/16 (1 = Best, 100 = Worst) 0 Universe Ranking th 46th 48th 38th 56th 47th 28th 23rd Year 3 Years 5 Years 10 Years TUCS Universe > $1B (GOF) InvestorForce Public DB > $1B 2 On June 13, 2014, the SURS Board of Trustees approved lowering the System s assumed rate of investment return to 7.25% from 7.75%. The rate was effective as of June 30, (July 2, 2015 was the effective date for the change in the Money Purchase Factors.) 3 F Y2017 Investment Plan

10 Fiscal Year 2016 Accomplishments The following projects were completed during Fiscal Year In total, asset reallocations and new commitments of approximately $1.7 billion took place or were approved during FY Self-Managed Plan (SMP) A Request for Proposal was released in May 2015 to identify two or more qualified SMP service providers. The process concluded in September 2015 with the retention of Fidelity Investments and TIAA-CREF as recordkeeping service providers. In addition, Fidelity was selected as the lead administrator for the SMP. Private Equity In June 2015, SURS initiated a search to identify a private equity emerging manager fund of funds provider. The mandate is designed to focus exclusively on private equity funds with greater than 51% ownership held by minorities, females, or persons with a disability, as defined by Illinois statute. This allocation will assist SURS in meeting its 20% diversity goal, as documented in the Investment Policy. The search concluded in March 2016 when the Board committed $100 million to Muller & Monroe. In addition, in June 2016, SURS committed $150 million to Adams Street Partners to continue SURS investment in global private equity. These commitments, made in accordance with the current private equity funding plan, allow for consistent funding by vintage year and further enhance the diversification of the private equity portfolio. Real Estate During FY 2015, a search was completed for qualified non-core real estate managers, resulting in the hiring of one fund-of-funds provider and three direct real estate investment managers. Commitments to the four managers totaled $195 million and are in accordance with the current real estate funding plan approved during Fiscal Year All four managers began calling capital during FY These new allocations enabled SURS to achieve the policy target allocation to real estate during the fiscal year. Hedged Strategies A search was initiated in December 2014 to identify diversified, multi-strategy Fund of Hedge Fund providers. This search represents phase I of the implementation of the 5% hedged strategies allocation approved at the June 2014 meeting. In October 2015, KKR Prisma and Pacific Alternative Asset Management Company (PAAMCO) were selected by the Board to manage a total of 3% of the portfolio in hedge fund-of-fund strategies. Initial funding took place late in FY Commodities In June 2015, the Board approved a search to identify qualified active commodities managers. The search concluded in December 2015 when PIMCO and Invesco were selected and allocated a total of 2% of the total portfolio, in accordance with the June 2014 asset/liability study. Initial funding took place late in FY Portfolio Index Option Overlay - At the September 2015 Investment Committee meeting, the Board approved a motion to conduct a search to identify qualified providers for portfolio overlay strategies. The strategy is designed to generate incremental income to the portfolio. The search concluded with the selection of Gladius Capital Management in April Contract negotiations on this strategy are currently underway. Gladius is a minority-owned firm. 4 FY2017 Investment Plan

11 Alternative Investments SURS made net contributions of $112 million to the alternative investments program during calendar 2015, as shown in the following table. In total, the combined alternative investments program made $204 million in contributions and received $316 million in distributions during calendar year Asset Class Alternative Investment Cash Flows Calendar Year 2015 Cash Distributions ($MM) Cash Contributions ($MM) Net Flows ($MM) Private Equity $ 259 $ (134) $ 125 Direct Real Estate 56 (63) (7) Infrastructure 1 (7) (6) Total Alternative Investments $ 316 $ (204) $ (112) *Totals may not add due to rounding. Commitment to Diversity SURS continues to be strongly committed to diversity throughout the investment program. In total, 19 firms owned by minorities, females, or persons with a disability (MFDB) directly manage a total of $4.2 billion, or 24.7% of the Total Fund, as of June 30, SURS employs a multi-strategy approach designed to maximize opportunities for qualified firms. The Manager Diversity Program (MDP) is a SURS-sponsored initiative designed to identify and provide opportunities to highly successful MFDB investment management firms. Managers in the MDP contract directly with SURS. As of June 30, the MDP totals $2.7 billion and includes 17 minorityor female-owned investment managers (19 strategies). Increase in MDP assets of approximately $110 million during fiscal year Second, SURS has retained Progress Investment Management (Progress), a minority-owned firm, to serve as a manager of emerging managers. This collaboration with Progress allows SURS to extend its reach into the minority manager universe. As of June 30, the Progress program includes 12 minority- or female-owned investment managers and has total assets of $383 million. The program includes investments in the non-u.s. equity, core fixed income, and emerging market debt asset classes. It is important to note that SURS commitment to diversity extends beyond the bounds of the MDP and the Manager of Emerging Managers Program. In addition to the firms previously mentioned, SURS contracts with one other MFDB firm, bringing the total number of MFDB firms in direct partnership with SURS to 19. As mentioned previously, assets managed for SURS by these 19 firms are approximately $4.2 billion, or 24.7% of the Total Fund, as of June 30, F Y2017 Investment Plan

12 Trustee Education Various educational topics were addressed during FY 2016, including asset allocation, hedge funds, commodities, and fee transparency, and a Trustee Educational Forum in February 2016, discussing Board governance, the Self-Managed Plan and diversity opportunities. Challenges The continuing challenge to SURS remains the funding status of the Plan. Despite strong long term returns, SURS remains substantially underfunded. SURS is approximately 41.1% funded, as of June 30, 2016 (using the market value of assets method and a 7.25% return assumption), a slight decrease from 44.2% funded, as of June 30, *Using market value of assets The unfunded liability is estimated to be approximately $24.1 billion. It is important to note, however, that since FY 2011, SURS has received the full annual statutory contribution from the State of Illinois. The FY 2016 contribution is $1.6 billion. The Plan s cash needs continue to increase. SURS expects to pay approximately $2.41 billion in benefit payments in Fiscal Year 2017, per the Fiscal Year 2015 actuarial valuation report prepared by SURS actuary, Gabriel Roeder Smith & Company. $2,500 $2,000 Total Benefit Expenditures & State Contributions (in $ Millions) $1,500 $1,000 $500 $0 6 FY2017 Investment Plan Total Benefit Expenditures State Contribution

13 Trustee & Staff Education SURS strives to provide high quality continuing education for the Board of Trustees and the staff. Educational topics are routinely included on Investment Committee agendas. In addition, longer, more in-depth educational sessions, often faciliated by guest speakers, are provided in periodic Investment Forums. These sessions provide both staff and Trustees the opportunity to expand their investment knowledge and keep current with new trends in the marketplace. Input is sought from Trustees on topics of interest for future educational sessions. A key focus is on identifying potential investment opportunities that could positively impact the investment portfolio. Potential educational topics being considered for the coming year include: Asset Allocation & Portfolio Strategy Benchmarking and Structure of Public Market Asset Classes Hedged Strategies Private Equity Real Estate Fixed Income Corporate Governance SURS continues to place a high priority on corporate governance. Proxy voting is one important component of the System s corporate governance responsibilities. SURS has retained an industry expert, Marco Consulting Group, to ensure that all domestic proxy ballots are voted in accordance with the proxy voting guidelines approved by the Board. Proxies of non-domestic shares are voted by SURS investment managers in the exclusive interests of System participants and beneficiaries. During fiscal year 2016, Marco Consulting Group provided an annual summary of the 2016 proxy season to the SURS Board. The Board also conducted an annual review and approval of the SURS Proxy Policy Statement. A search for a provider of proxy voting services is currently underway, with a recommendation to the Board tentatively scheduled for September Additional actions pertaining to corporate governance include membership in the Council for Institutional Investors (CII), a nonprofit organization of pension funds, foundations, and endowments with combined assets of over $3 trillion. CII s mission is to educate its members, policymakers and the public about corporate governance, shareowner rights and related investment issues, and to advocate on members behalf. In addition, SURS is a signatory to the United Nations-backed Principles for Responsible Investment (PRI) initiative. The PRI initiatives are voluntary principles that acknowledge the importance of environmental, social and corporate governance (ESG) issues to company performance. SURS strives to keep abreast of trends and issues in this area and continues to explore efforts that might safeguard the value of the investment portfolio. SURS seeks to raise awareness of PRI with others in the investment management industry. Currently, NEPC, SURS investment consultant, and 14 of SURS investment managers are signatories to PRI, representing over half of the SURS assets. 7 F Y2017 Investment Plan

14 Investment Management Fees SURS pays close attention to the level of investment management fees paid to its external investment managers. Fees are negotiated with investment managers prior to the commencement of the relationship with SURS and may be subsequently renegotiated, if appropriate, especially in instances where an investment manager receives an additional allocation(s). Fees vary significantly among investment managers, with the services of private markets managers, such as those in real estate, private equity, infrastructure, etc., being generally higher than those of public markets managers. During fiscal year 2016, staff negotiated more favorable fee arrangements with nine new and existing investment managers. In aggregate, these fee reductions are expected to result in approximately $1.1 million in fee savings. In total, SURS paid $58.4 million or approximately 35 basis points in investment management fees and administrative expenses for fiscal year Total investment management fees for fiscal year 2017 are projected to increase by approximately $1.3 million from fiscal year 2016 budgeted fees. Staffing The Investment Department is made up of seven investment professionals. The Senior Investment Accounting Officer also works in tandem with the Investment Department and is an integral part of overall investment operations. On August 1, 2016, Daniel Allen, Chief Investment Officer for the past 11 years, retired from the organization. SURS thanks Dan for his commitment, dedication and service to the SURS membership and staff and wishes him well in the future. A search to fill the resulting vacancy is currently in progress. Also, in the past year, SURS added one Investment Officer to fill a vacant position. SURS Investment Team members have an average of approximately 17 years investment experience. All investment team members have undergraduate degrees, with the majority also holding graduate degrees. Professional certifications among the team members include two Certified Public Accountants (CPA), four Chartered Financial Analysts (CFA), and one Chartered Alternative Investment Analyst (CAIA). During the past several years, SURS has been increasing the portfolio s allocation to alternative investments. While alternative assets offer the benefits of diversification and potential return enhancement, they also require more intensive staff resources for administration and monitoring. Accordingly, as allocations to private market investments have increased, the investment staff has grown modestly in response. These new hires will augment staff resources to monitor and administer the investment portfolio. Staffing needs will continue to be assessed going forward. The SURS Investment Department employed two interns for the summer of 2015 from Eastern Illinois University and one intern for the summer of 2016, also from Eastern Illinois University. One intern continues to be employed at SURS. The interns were placed with the assistance of the Toigo Foundation. SURS is committed to staff development and training to assist employees in realizing their maximum potential. In addition, SURS continues to strive to maintain competitive compensation and promote a positive workplace environment for all employees. 8 FY2017 Investment Plan

15 The table below lists the individuals on the SURS Investment Team and their tenure with SURS. Name Title Years with SURS Vacant Chief Investment Officer - Douglas C. Wesley, CPA, CFA Deputy Chief Investment Officer 19 Kimberly K. Pollitt, CFA Senior Investment Officer, Equities 13 Joseph M. Duncan Senior Investment Officer, Fixed Income 6 Shane P. Willoughby, CFA, CAIA Investment Officer, Real Assets 2 Alex Ramos Investment Officer 2 Brian DeLoriea, CFA Investment Officer 1 Lou Ann Fillingham, CPA Senior Investment Accounting Officer 11 Kelly Valle Graduate Investments Intern 1 An organizational chart of the Investment Department is shown on the following page. 9 F Y2017 Investment Plan

16 10 FY2017 Investment Plan SURS Investment Department Organization Chart June 30, 2016

17 Outreach SURS believes active involvement in the investment community is beneficial at both the individual and organizational levels. Continuing education, networking opportunities and increased organizational visibility are a few of the many benefits. The list below highlights the various organizations of which SURS or SURS investment staff are members: American Institute of CPAs (AICPA) CFA Institute CFA Institute of Chicago Chartered Alternative Investment Analyst Association Council of Compliance Officers Council of Institutional Investors Institutional Limited Partners Association (ILPA) Institutional Society of Risk Professionals (ISRP) National Association of Securities Professionals (NASP) National Association of State Investment Officers (NASIO) National Association of State Investment Professionals (NASIP) New America Alliance Pension Real Estate Association Robert Toigo Foundation Board of Directors United Nations Principles for Responsible Investment (UNPRI) In addition, SURS staff attended and/or participated as panelists in several investment-related conferences throughout the fiscal year. SURS staff also attended a myriad of advisory council and annual meetings for SURS investment managers as part of annual due diligence efforts. 11 F Y2017 Investment Plan

18 III. Asset Allocation / Risk Management Asset Allocation The purpose of the asset allocation policy is to establish an Investment Policy framework for SURS with a high likelihood, in the Board s judgment, of realizing SURS investment objective. The most recent asset/liability study was completed in June 2014 with the assistance of NEPC. The purpose of the study was to review the projected financial status of the pension plan over the next several years and to assess the appropriateness of the current asset allocation relative to the expected progress of liabilities and cash flows. The asset mix ultimately selected by the Board is expected to improve the portfolio s risk/return profile by diversifying away from equities into relatively uncorrelated asset classes. A similar growth profile is expected while downside protection is enhanced. SURS plans to formally revisit asset allocation targets in early Liquidity Considerations Investment portfolios can benefit from a portion of assets in illiquid investments. However, illiquid investments add another dimension to liquidity management. Liquidity to pay benefits and respond to adverse funding or financial market downturns is critical. As part of the recent asset-liability study, NEPC conducted a liquidity analysis to determine how the SURS investment portfolio would respond to a stressed market scenario. The study projected sound liquidity of the portfolio in the base case environment but acknowledged that, in a stressed case, the Plan would consume a significant portion of liquidity sources over six years. Overall, NEPC determined the SURS portfolio would likely continue to benefit from maintaining diversified exposure to illiquid assets. Although it is reasonable to plan to receive the statutory contributions from the State, it is important to acknowledge there is a risk of receiving a level of contributions less than the required amount. SURS prospective funding experience will be critical in determining the future financial health of the System. The certified contribution for FY 2017 is approximately $1.7 billion. Capital Market Assumptions The projected return and risk assumptions used in the process were developed by NEPC. NEPC s most recent capital market projections, which are refreshed annually, are shown in the tables on the following pages and generally reflect moderately higher return expectations among global equity and credit assets compared to last year s 5-7 year return assumptions. Capital market expectations represent passive exposure (i.e., beta only). Return expectations are net of passive fees. 12 FY2017 Investment Plan

19 NEPC Capital Market Projections Projected Risk and Return 5-7 Year Return Assumptions 30 Year Return Assumptions Asset Class Cash 1.75% 1.50% -0.25% 3.25% 3.00% -0.25% Treasuries 1.75% 1.75% 3.50% 3.25% -0.25% IG Corp Credit 3.25% 3.75% 0.50% 4.75% 5.00% 0.25% MBS 2.00% 2.00% 3.75% 3.50% -0.25% Core Bonds* 2.30% 2.46% 0.16% 3.98% 3.89% -0.09% TIPS 2.25% 2.50% 0.25% 4.00% 4.00% High-Yield Bonds 4.00% 5.25% 1.25% 5.75% 5.75% Bank Loans 4.50% 5.50% 1.00% 6.00% 6.00% Global Bonds (Unhedged) 1.00% 1.00% 2.25% 2.75% 0.50% Global Bonds (Hedged) 1.13% 1.09% -0.04% 2.41% 2.87% 0.46% EMD External 4.50% 4.75% 0.25% 6.00% 6.00% EMD Local Currency 5.50% 6.50% 1.00% 6.75% 6.50% -0.25% Large Cap Equities 6.00% 6.00% 7.50% 7.50% Small/Mid Cap Equities 6.00% 6.25% 0.25% 7.75% 7.75% Int'l Equities (Unhedged) 7.00% 7.25% 0.25% 8.00% 8.00% Int'l Equities (Hedged) 7.39% 7.57% 0.18% 8.47% 8.39% -0.08% Emerging Int'l Equities 9.00% 9.75% 0.75% 9.25% 9.50% 0.25% Private Equity 8.50% 8.50% 9.50% 9.50% Private Debt 7.50% 7.50% 8.00% 8.00% Private Real Assets 8.00% 8.25% 0.25% 7.75% 7.75% Real Estate 6.50% 6.50% 6.50% 6.50% Commodities 5.25% 4.50% -0.75% 5.75% 5.50% -0.25% Hedge Funds 5.75% 5.75% 6.75% 6.50% -0.25% Return assumptions are geometric. *Core Bond assumptions are based on market weighted blend of components of Aggregate Index (Treasuries, IG Corporate Credit, and MBS). 13 F Y2017 Investment Plan

20 2016 Volatility Forecasts Volatility Asset Class Cash 1.00% 1.00% Treasuries 5.50% 5.50% IG Corp Credit 7.50% 7.50% MBS 7.00% 7.00% Core Bonds* 6.03% 6.03% TIPS 7.50% 6.50% -1.00% High-Yield Bonds 13.00% 13.00% Bank Loans 8.00% 9.00% 1.00% Global Bonds (Unhedged) 9.00% 8.50% -0.50% Global Bonds (Hedged) 5.00% 5.00% EMD External 12.00% 13.00% 1.00% EMD Local Currency 15.00% 15.00% Large Cap Equities 17.50% 17.50% Small/Mid Cap Equities 21.00% 21.00% Int'l Equities (Unhedged) 21.00% 21.00% Int'l Equities (Hedged) 17.50% 18.00% 0.50% Emerging Int'l Equities 26.00% 27.00% 1.00% Private Equity 27.00% 23.00% -4.00% Private Debt 17.00% 15.00% -2.00% Private Real Assets 23.00% 20.00% -3.00% Real Estate 15.00% 15.00% Commodities 18.00% 19.00% 1.00% Hedge Funds 9.00% 9.00% Volatility defined as standard deviation of investment returns. *Core Bonds assumption based on market weighted blend of components of Aggregate Index (Treasuries, IG Corporate Credit, and MBS). 14 FY2017 Investment Plan

21 Strategic Policy Targets The strategic policy targets resulting from the most recent asset/liability study are shown in the following table. Using NEPC s 2016 risk and return projections, a passive portfolio composed in such a manner is projected to produce a geometric return of 6.4% over the five to seven year period, falling short of the 7.25% actuarial rate of investment return 3. (Note: SURS returns have significantly exceeded the actuarial rate of return over the long term, as evidenced by the 8.1% 25-year return). Over the long term, however, the projected return is 7.5%, higher than the return assumption. Also, it is important to note active management is projected to add additional value over and above passive implementation. SURS periodically reviews the actuarial return assumption for reasonableness. Asset/Liability Study Results Strategic Policy % (Approved June 2014) Asset Class U.S. Equity 23% Non-U.S. Equity 19% Global Equity 8% Total Public Equity 50% Core Fixed Income 19% Emerging Market Debt 3% TIPS 4% Total Fixed Income 26% Private Equity 6% Real Estate 6% REITs 4% Hedged Strategies 5% Opportunity Fund 1% Commodities 2% Total Alternatives 24% Total 100% 5-7 Yr. Expected Return 6.4% Standard Deviation 12.5% 30 Yr. Expected Return 7.5% Sharpe Ratio 0.39 Compared to the return projections using NEPC s 2015 capital market assumptions, the 2016 return projection is slightly higher (6.4% in 2016 vs. 6.2% in 2015). The modest increase in the return projection is a result of slightly higher return expectations among global equity and credit assets as shown in the Capital Market Projections table.. 3 On June 13, 2014, the SURS Board of Trustees approved lowering the System s assumed rate of investment return to 7.25% from 7.75%. The rate is effective as of June 30, F Y2017 Investment Plan

22 Risk Management Risk is monitored through various forms of analysis and reporting in an attempt to understand risks within the Fund, and to ensure adequate compensation for the level of risk assumed. Analysis will occur at various levels of detail, which include individual manager, asset class and total Fund. In addition to relative performance evaluation, an analysis of diversification, benchmark risk, active risk, total risk, value at risk, and other risk measures will be reported. Analysis will be conducted on an ex-post and ex-ante basis to identify and quantify both forward looking and backward looking risk metrics. Staff will review portfolios, asset classes, and total Fund information on an ongoing basis in order to maintain an understanding of potential risks within the portfolio. Individual manager portfolios or asset classes demonstrating higher than expected levels of risk will be examined in greater detail and any necessary adjustments will be made immediately, or a plan for doing so will be developed. Alternatively, justification for maintaining the exposure will be provided to the Investment Committee. Shown below and on the following pages is a sampling of risk analytics produced by NEPC and The Northern Trust Company, SURS custodian, to assist SURS in monitoring the risk profile of the Total Fund. Total Fund Risk and Return Source: NEPC 16 FY2017 Investment Plan

23 Total Fund vs. InvestorForce Public DB > $1B Gross 5 Years Ending 6/30/16 Source: NEPC 17 F Y2017 Investment Plan

24 Risk Trends and Overview 100% Contribution to Total Risk % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Jun-16 Mar-16 Dec-15 Sep-15 Jun-15 Mar-15 Dec-14 Sep-14 Jun-14 Mar-14 Dec-13 Sep-13 Jun-13 Mar-13 Total Equity Total Fixed Real Estate Opportunity Fund Hedged Equity Commodities 14.00% Total Plan Risk (1 Year Forward Looking) 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Jun-16 Mar-16 Dec-15 Sep-15 Jun-15 Mar-15 Dec-14 Sep-14 Jun-14 Mar-14 Dec-13 Sep-13 Jun-13 Mar-13 Total Risk Source: The Northern Trust Company 18 FY2017 Investment Plan

25 IV. Economic Outlook A variety of sources were used to develop this outlook for Fiscal Year Consideration was given to information from investment consultants, investment managers, discussions with peers and informational publications. Summary: The outlook for the U.S. economy remains healthy but debatable. According to the FOMC meeting forecast released on June 16 th, 2016, the U.S. GDP growth in 2016 will be 2%, slightly slower than in 2015, and it will remain at 2% in 2017 and The unemployment rate is forecasted to be 4.7% in 2016 and to slightly drop to 4.6% in 2017, lower than the 6.7% Fed target. Structural unemployment has increased as people have not been able to return to their pre-crisis high-paying jobs. Britain s vote to leave the European Union, Brexit, revealed growing dissatisfaction with globalization and the political elite. According to the IMF, Brexit has negatively affected the global economy by substantially increasing economic, political, and institutional uncertainty. Although Brexit could send the U.K. economy into a recession and slow down the economy of the euro-area, it is expected that policymakers will ensure a smooth and predictable transition, thus avoiding a euro crisis and greatly minimizing any negative impact on the global economy. The IMF estimates that the U.K. economy will expand 1.7% this year and it will slow down to 1.3% in Asia s economic growth forecasts remain positive. It is expected that the region will expand by 5.6% in 2016 and 5.7% in China is expected to meet the forecast growth of 5.6% in 2016 and 6.3% in India is expected to grow by 7.4% in 2016 and 7.8% in Central Asia has been affected by fiscal pressures from continued low oil prices, resulting in a downward adjustment to growth of 0.4% to 1.7% in 2016 but expected to rise in 2017, according to the Asian Development Bank. The Fed continues to monitor the timing of rate hikes as consumption growth increases but industry and investment spending have not shown signs of acceleration. Economic uncertainty in Europe has also played a role in the delay of rate-related decisions. In addition, the U.S. presidential election has exposed dissatisfaction with the status quo, translating into added economic uncertainty and negatively affecting corporate investment plans. Additional rate hikes are not expected until after the U.S. elections. Current Yield as of US Treasury Market June 30, 2015 June 30, 2016 % Change 3-Month Treasury Bill 0.01% 0.26% 0.25% 2-Year Treasury Note 0.64% 0.58% -0.06% 5-Year Treasury Note 1.65% 1.00% -0.65% 10-Year Treasury Bond 2.35% 1.47% -0.88% 30-Year Treasury Bond 3.12% 2.28% -0.84% 3-Month LIBOR 0.28% 0.65% 0.37% IL Gen Obl 7-Yr PU9 3.71% 2.96% -0.75% 5.0% US Treasury Yield Curve Yield to Maturity 4.0% 3.0% 2.0% 1.0% 19 F Y2017 Investment Plan 0.0% Month 2 Year 5 Year 10 Year 30 Year Years to Maturity 6/30/2015 6/30/2016

26 V. Fiscal Year 2017 Portfolio Strategies Financial Goal & Strategic Objectives The assets of the System will be invested solely for the benefit of participants and beneficiaries within the constraints of applicable Illinois Statutes and the guidelines contained in the SURS Investment Policy document and each manager s Investment Management Agreement. In addition, the following financial goal and strategic objectives for the SURS plan have been established: The SURS Financial Goal The financial goal as set forth in the SURS Strategic Plan is: To ensure the financial soundness of the System. The strategic objectives designed to achieve the SURS Financial Goal are as follows: Secure the annual required contribution Achieve long term, sustainable, above average, risk-adjusted returns Manage the risk and volatility of assets and liabilities to assist in maintaining sufficient funds to pay benefits and mitigate the cost of contributions Manage expense at an optimal level to achieve the greatest return on investment. Make modifications to benefit/plan design as required In addition, SURS has a goal of protecting assets through sound risk management and ethical practices. Strategic Policy Asset Allocation Targets Over time, the investment portfolio has undergone meaningful change as a result of the availability of new investment strategies and changes in capital market assumptions. The public equity portfolio has become increasingly global in nature. In addition, alternative asset classes, including private equity and real estate, have assumed a more prominent role in the investment program over the past decade. In June 2014, after concluding an asset/liability study, the Board approved new strategic policy targets. The asset mix approved at that time includes a reduction in public equity exposure by ten percentage points and the introduction of new investments in hedged strategies, emerging market debt and commodities. The reduced strategic policy allocation to public equities is a result of lower return expectations in these asset classes after periods of above trend returns. By allocating assets from public equities to other areas such as emerging market debt, hedged strategies and commodities, SURS is able to reduce the overall expected risk of the portfolio while maintaining the target level of expected return. The following table illustrates the portfolio s current asset allocation (as of June 30, 2016) relative to the new strategic policy targets and also illustrates the progress made implementing the new policy targets since June 30, FY2017 Investment Plan

27 Asset Class Strategic Policy % (Approved June 2014) 6/30/2015 Actual % 6/30/2016 Actual % 6/30/2016 Over / (Under) vs. Policy % U.S. Equity 23.0% 29.3% 25.5% +2.5% Non-U.S. Equity Global Equity Total Public Equity 50.0% 56.1% 52.4% +2.4% Core Fixed Income Emerging Market Debt TIPS Total Fixed Income 26.0% 27.1% 27.0% +1.0% Private Equity Real Estate REITs Hedged Strategies Opportunity Fund Commodities Total Alternatives 24.0% 16.8% 20.6% -3.4% Grand Total* 100.0% 100.0% 100.0% 100.0% *Totals may not add due to rounding. Implementation of the strategic policy targets is nearly complete, with the primary exception being the remaining 2% allocation to hedged strategies. Fiscal Year 2017 Total Fund Strategy The following actions are planned for the coming fiscal year. Private Equity At the June 2014 Investment Committee meeting, the Board approved the adoption of a three-year private equity funding plan designed to maintain SURS private equity allocation at 6%. The funding plan included annual allocations of: Available Commitment Amount 2015 $250 million $125 million 2016 $300 million $250 million Calendar Year 2017 $300 million -- Total $850 million Commitments Approved to Date The Board approved a private equity fund-of-funds search at their April 21, 2016 meeting. At the conclusion of the search, tentatively scheduled for December 2016, commitments will resume to the private equity asset class. In addition, a private equity funding plan for calendar years will be developed and presented to the Board in June Non-Core Real Estate In September 2014 the Board approved a real estate funding plan for calendar years designed to achieve and maintain SURS private real estate allocation at 6%. The three-year funding plan totaling $300 million included 21 F Y2017 Investment Plan

28 annual commitments of $100 million. To date, $195 million has been allocated, leaving the final $105 million to allocate in In addition, a real estate pacing model for will be developed and presented to the Board for consideration during Fiscal Year Hedged Strategies Staff and NEPC will continue to work with the Board to review the remaining 2% allocation to hedged strategies. Throughout the Fiscal Year Asset Class Structure Studies Staff will be working with the Investment Consultant, NEPC, to review each asset class in depth in an attempt to identify further efficiencies within the SURS Investment Portfolio. Results of the studies and recommendations for change, if applicable, will be presented to the Investment Committee for discussion and consideration. Ongoing Responsibilities Diversity Initiatives SURS will continue to review opportunities in the investment program to consider the utilization of minorities, females and persons with a disability. Investment managers of diversity are always encouraged to participate in the search process if an applicable strategy/mandate is identified. o As of June 30, 2016, the MDP is valued at approximately $2.7 billion and includes 17 MFDB investment management firms and 19 strategies. o Progress Investment Management (Progress), a minority-owned firm, serves as a manager of emerging managers for SURS. As of June 30, the Progress program includes 12 minority- or female-owned investment managers with 14 mandates and has total assets of $383 million. SURS commitment to diversity extends beyond the bounds of the MDP. In addition to the programs previously mentioned, SURS contracts with one other MFDB firm, bringing the total number of MFDB firms in direct partnership with SURS to 19. As mentioned previously, assets managed for SURS by these 19 firms are approaching $4.2 billion, or 24.7% of the Total Fund, as of June 30, SURS is currently in discussions to potentially host an outreach event with other Illinois public pension systems to provide opportunites for the sharing of information between the MFDB firms and the pension systems. Objectives of the event include to increase SURS knowledge of the minority investment management community, inform the firms of SURS procurement policies, provide contact points within the organization, and distribute information on upcoming opportunities within the portfolio. As SURS reviews the structure of each asset class during the coming fiscal year, a primary focus will be to search for opportunities to increase diversity in each segment of the portfolio. Investment Manager Oversight, Due Diligence and Risk Management A critical duty of the investment team and NEPC is to monitor the numerous investment managers under contract with SURS. Each manager plays a role in the success of the overall 22 FY2017 Investment Plan

29 program and extensive resources are utilized to ensure the strategies are functioning as desired. Risk management monitoring of the program continues to expand and evolve. Enhancements to Manager Performance Reporting Staff will continue to work with the Board to fine-tune the performance reports to provide an optimal mix of risk and return measures to better aid in decisionmaking. Fees and Compliance Oversight SURS continuously strives to obtain the most favorable fee terms from investment providers. Negotiations during FY 2016 resulted in annual savings of over $600,00, as well as one-time savings of approximately $480,000. Compliance monitoring efforts includes continuous interaction with NEPC as well as the custodian, Northern Trust. Investment Policy Throughout the year, staff reviews the existing Investment Policy and makes note of any revisions to further improve the document. Annually at the September meeting, staff presents an updated Investment Policy to the Board for review and consideration. Trustee input into the Policy is appreciated. Trustee and staff education will continue to be a priority during Fiscal Year Fiscal Year 2017 Public Equity Strategy The primary focus in fiscal year 2017 will be working with NEPC to conduct a structure analysis for the asset class to determine the most efficient means of positioning the public equity portfolio. In the aggregate, the public equity portfolio (U.S., non-u.s. and global equity) is 2.4% overweight relative to the new strategic policy target. US Equity 23% Non-US Equity 19% Global Equity 8% Continued emphasis will be on monitoring the portfolio and underlying investment managers for performance that meets or exceeds expectations and for compliance with the Investment Policy and investment manager guidelines. NEPC, the general investment consultant for SURS, will assist in the monitoring and strategy efforts. Fiscal Year 2017 Fixed Income Strategy A key focus during Fiscal Year 2017 will be a review and assessment of the core fixed income portfolio to determine the optimal structure in what is likely to be a rising interest rate environment going forward. Additional fixed income mandates may be considered in order to provide further diversification and enhance returns. The portfolio will continue to be monitored to ensure that the underlying investment managers meet or exceed expectations for performance as well as compliance with the Investment Policy and investment manager guidelines. NEPC will assist in the monitoring and strategy efforts. Emerging TIPS Market Debt 4% 3% 23 F Y2017 Investment Plan Core Fixed Income 19%

30 Alternative Strategies Fiscal Year 2017 Real Estate Strategy As of June 30, 2016, investments in real estate investment trust securities (REITs) comprise 4.1% of the total portfolio, and investments in private real estate investments total 5.9% of the portfolio. The long-term strategic policy target mix allocates 4% to REITs and 6% to private real estate. Commitments to non-core real estate managers during FY 2016 have eliminated the previous 1.0% underweight to private real estate. In September 2014, the Board approved a three year pacing model totaling $300 million for calendar years Thus far, $195 million in commitments have been approved. The remaining $105 million will be committed over the course of calendar years to stay on course with the real estate pacing analysis and will continue to focus on the non-core segment of the real estate market. A real estate pacing model for will be developed and is scheduled to be presented to the Board for consideration during Fiscal Year The chart that follows illustrates the diversification of the real estate portfolio by type, as of June 30, SURS Real Estate Portfolio Diversification by Type Non-Core Real Estate 15% REITS 41% Real Estate 10% Core Real Estate 43% *Based on current market values Fiscal Year 2017 Private Equity Strategy As of June 30, 2016, the private equity portfolio comprises 5.4% of the total portfolio, slightly under the strategic policy target of 6.0%. The private equity portfolio is broadly diversified by vintage year, subclass and geography. Private Equity 6% 24 FY2017 Investment Plan

31 In June 2014, the Board approved a three-year private equity funding plan for calendar years , totaling $850 million. The plan allows for consistent funding by vintage year to continue the System s quality private equity program. The Board approved a private equity fund-of-funds search at their April 21, 2016 meeting. At the conclusion of the search, tentatively scheduled for December 2016, commitments will resume to the private equity asset class. In addition, a private equity funding plan for calendar years will be developed and presented to the Board during FY Fiscal Year 2017 Hedged Portfolio Strategy A 5% strategic policy allocation to hedged strategies was included as a part of the strategic policy mix approved by the Board in June Implementation of phase I of the hedged strategies portfolio has been completed with 3% of the portfolio allocated to two hedge fund-offunds providers. The Board is currently reviewing the remaining 2% allocation to hedged strategies. Hedged Strategies 5% Fiscal Year 2017 Opportunity Fund Strategy Currently, infrastructure investments are the sole component of the Opportunity Fund. In April 2016, the Board retained an equity index option overlay strategy. The income producing strategy will be initiated during FY2017. Additional opportunities arising during Fiscal Year 2017 may be brought to the Board s attention, if appropriate. Opportunity Fund 1% Fiscal Year 2017 Commodities Strategy The strategic policy mix approved by the Board in June 2014 includes a 2.0% strategic policy allocation to commodities. This allocation is one element of the plan to reduce SURS public equity exposure and increase the portfolio s diversification. Initial passive commodities exposure was gained synthetically via the cash overlay manager. A search for qualified active commodities investment managers concluded in FY 2016, with the selection of two active managers to provide commodities exposure to the portfolio. Commodities 2% Fiscal Year 2017 Cash Overlay Strategy A cash overlay program was implemented in September The program is designed to assist the Plan in remaining fully invested consistent with policy targets and to efficiently manage exposure to cash flows. The overlay program also allows efficient implementation of rebalancing and changes to asset allocation targets. 25 F Y2017 Investment Plan

32 Projected Timeline A chart illustrating a projected timeline of the major investment projects slated for Fiscal Year 2017 is shown on the following pages. It should be noted that other projects may arise during the fiscal year, including, but not limited to, potential manager terminations or other ad hoc projects. 26 FY2017 Investment Plan

33 (This Page Intentionally Left Blank) 27 F Y2017 Investment Plan

34 SURS FY 2017 Investment Timetable Topic Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Global Private Equity Fund-of-Funds Contract negotiations Search (start April-16) Consideration of FY 2017 Investment Plan Annual Review of Investment Policy Annual Review of Diversity Goals Education - Topics TBD Review of Non-US and Global Equity Asset Classes Annual Review of Investment Policy (cont'd) Annual Broker/Dealer Review Education - Topics TBD Annual Review of Passive Portfolio Annual Review of Real Estate Asset Class Receipt of Annual Report to the Governor on Utilization of Emerging Firms Education - Topics TBD Annual Review of Fixed Income and Emerging Market Debt Asset Classes Trustee Educational Forum Annual Review of Commodities Asset Class Annual Review of Hedged Strategies Asset Class Education - Topics TBD 28 FY2017 Investment Plan